Most
of the upward pressure on oil prices is the result of increases in
demand and potential supply disruptions that are unlikely to disappear
any time soon

By HENRY T. AZZAM
Sep 20 - 26, 2004

Oil prices surged to a new record high close to $50 a
barrel in the US market recently before adjusting lower, supported by
strong world demand especially from the US and China, limited production
increases from the major oil producers, worries about the security of
supply from the Middle East region, uncertainties associated with
Russia's oil production following the collapse of the oil giant Yukos
which exports 1.3 million bpd, strong buying by the hedge funds and
minimal excess production capacity still available for OPEC. Taken
together all these factors could spell a new era of higher oil prices
with Brent crude remaining above $35 a barrel in 2005. This should help
maintain the current economic up cycle in the region for the third year
in a row.

The US government has decided recently to raise its
central price forecast for US crude prices over the next 18 months to
$37 a barrel. OPEC is talking about a higher price range of $28-$35 for
OPEC crude, up from the current range of $22-$28. The price of OPEC
basket of crude oil usually trades $3 to $4 a barrel below the West
Texas Intermediary (WTI), the US benchmark for crude oil. The
International Energy Agency (IEA) also revised its estimates for crude
oil prices through 2005 to be higher than $34 a barrel for Brent curde.

The average Brent crude kept above $24.5 a barrel for
four years running, and the whole oil price futures curve has moved up.
Average Brent crude prices per barrel were $28.4 in 2000, $24.5 in 2001,
$25.0 in 2002, $28.48 in 2003 and $33.8 in the first half of 2004. This
year's average could reach $35 a barrel, or 22 percent higher than last
year's average. The price for delivery as far as 2010 is now close to
$30 a barrel. This shows that markets have abandoned the belief that
long-term oil prices will stay in a range of $18 to $24 a barrel. In
fact, in a recent speech, the Federal Reserve Chairman Alan Greenspan
noted that the long-term oil future market suggests that oil prices are
going to stay firm for several years to come.

Most of the upward pressure on oil prices is the
result of increases in demand and potential supply disruptions that are
unlikely to disappear any time soon. On the demand side, the upturn in
US economic growth and the record sales of sport utility vehicles (SUVs)
have helped push up consumption by more than 4.6 percent over the past
year. China and many other developing countries, have become much more
dependent on oil in recent years as their economies have moved from
agriculture to heavy manufacturing. In fact, china has just past Japan
to become the world's second largest oil consumer, and its demand for
oil which grew by 10 percent in 2003 is expected to increase by 20
percent this year, or the equivalent of 800,000 more barrels a day. With
the economic recovery in Japan and Europe picking up momentum, the IEA
is forecasting a net rise in world demand for oil of 2.8 percent, from
79.1 million bpd in 2003 to 81.3 million bpd this year.

Another factor propping up oil prices is the supply
disruption risk. Political uncertainty in Venezuela, Nigeria and
Indonesia have always undermined market's confidence in the security of
supply from these countries. A bigger aspect of the supply disruption
risk is the fear of terrorism that might be targeted at oil
infrastructure, especially in Iraq whose exports had frequently been
disrupted in the past few months. For now, Iraq is producing less than
1.5 million bpd, well below the 2.2 million bpd, of 1999-2002 when it
was exporting under the UN sponsored oil-for-food program. There is a
new worry that any attack, however small, on Saudi oil infrastructure
would have a noticeable impact on oil prices.

Another reason for higher oil prices may well be the
low real interest rates worldwide. Real interest rates are defined as
nominal rates less to the growth of consumer prices or inflation. Global
real interest rates are at a low point, with short-term real interest
rates in the US being negative. Oil prices have risen by about 48
percent over two years at a time where real interest rates were falling
(higher inflation with little change in nominal rates). Low real
interest rates make financial investments (bank deposits, bonds and
stocks) less attractive, while commodities, minerals and energy become a
better alternative. As in previous oil shocks, the rise in the price of
crude is accompanied by higher prices of other commodities. Nickel
prices have more than doubled in two years, while steel is up by 62
percent and gold by 25 percent. For real short-term interest rates to
move back to positive territories, the US's central bank would have to
raise interest rates by more than 2 percent from their current level of
1.50 percent. But this is considered way too aggressive given the
present situation of the US economy. The monetary aspect remains for the
time being supportive for higher oil prices.

The long-term is equally favorable for higher oil
prices. According to the IEA, world demand for oil is forecast to rise
more than 50 percent by 2025, to 120 million bpd, from 82 million bpd in
2004. China alone is expected to import as much oil as the US does now.
With a rising dependence on imported oil, the Chinese government's
decision to build up a strategic petroleum reserve of 165 million
barrels of oil by 2010 will boost demand further. There is little
political will on the part of the major consumers to push for
conservation. Even if they do, this will slow the growth in demand but
will not reverse it. On the supply side, the Middle East producers, who
currently account for about 28 percent of global production are set to
increase their share to 44 percent by 2025. Saudi Arabia alone sits on
about a quarter of the world's proven reserves, followed by Iraq and the
other Gulf states. On the other hand, the big oil reserves found in the
1970s in the North Sea and Alaska are on the decline and OPEC's output
has increased only marginally in the past three decades to reach 27
million bpd recently.

With strong growth in world demand for oil and with
non-OPEC members all producing at full capacity, this leads to question
marks over the oil production capacity available to meet world demand.
All the world's spare oil production capacity lies in the Gulf region,
mainly Saudi Arabia. However, with the Kingdom increasing its production
in the second half of the year to 9.1 million bpd, Saudi Arabia is left
with not more than 1.5 million bpd of immediately available spare
capacity. If Iraqi exports are persistently interrupted, most of this
idle capacity would be used up, leaving the world with a worryingly
small buffer against any further supply disruptions.

Stability in Iraq holds the key to oil price
movements in the months ahead. If Iraqi production is kept relatively
steady with occasional, but temporary, acts of sabotage slowing exports,
we can expect prices to ease from their recent heights, as other members
of OPEC and especially Saudi Arabia step in to make up for the shortfall
in Iraq's exports. However, a sustained loss of Iraqi oil exports could
not easily be compensated for. Any other disruptions to supply, for
example in Venezuela, Nigeria, or even Russia, would see oil prices
testing $50 a barrel again.